Validity of liquidated damages clause under Vietnam’s Law

Updated: 14:30’ - 07/04/2020

Liquidated damages is one of the important remedies that are widely known in various types of contracts. However, the validity of liquidated damages clause is still an uncertain thing under Vietnam’s law, giving rise to a number of disputes over this clause when being applied in Vietnam. This paper analyzes the validity of and recommends the way to deal with liquidated damages clause in accordance with Vietnam’s regulations on contracts.

Pham Ha Thanh Junior Legal Advisor of DFDL Vietnam

Liquidated damages (LD) is a monetary remedy recognized under many jurisdictions. Under liquidated damages clause (LD Clause), the contracting parties predesignate a reasonable amount of damages to be recovered by one party if the other party breaches. The fixed sum agreed is the measure of damages for a breach, whether it exceeds or falls short of the actual damage.[1] LD is normally in the form of a definite number or a formula.

Representatives of partners in Ha Nam province sign a cooperation contract on sale of fishes farmed with “river in pond” technology__Photo: Nguyen Chinh/VNA

LD Clause offers several benefits to the contracting parties. It can add predictability, especially in case it is difficult to determine the damage arising from the breaches. The enforcement of LD Clause promotes a quicker and earlier resolution of dispute, and reduces the expenses of litigation for the contracting parties.[2]

Vietnam’s legal framework governing liquidated damages clause

While LD Clause has been referred to in a number of international commercial contracts in Vietnam, its validity remains an unsure thing under Vietnam’s law, resulting in many disputes over the application and interpretation of this clause. Vietnam’s law adopts only two types of monetary remedies for a breach of contract, which are: (i) damage compensation and (ii) penalty. In this context, a legal issue arises as to whether LD Clause can be categorized into either damage compensation or penalty? What would be the most appropriate way to apply and interpret LD Clause in accordance with Vietnam’s law?

Liquidated damages clause as a damage compensation

Under Article 361 of the 2015 Civil Code, damage caused by a breach of an obligation includes physical damage and spiritual damage, of which physical damage is the actual losses that can be determined. In line with the approach under the 2015 Civil Code, Article 302.2 of the 2005 Commercial Law stipulates: “The value of damages covers the value of the actual and direct loss suffered by the aggrieved party due to the breach of contract and the direct profits which the aggrieved party would have earned if such breach had not been committed.” Accordingly, the scope of damage compensation under Vietnam’s law only accepts damage that actually and directly results from the breach.[3] Even when damage compensation is not provided in the contract, it would still apply as a matter of law if actual and direct damage can be proved by the aggrieved party.

Similar to damage compensation, LD serves for the purpose of compensating and mitigating losses caused by the defaulting party to the aggrieved one.[4] LD could be understood as an exception to damage compensation under Vietnam’s law, as it pre-estimates a sum of damages in the contract before actual damage can be determined. The question is, whether Vietnam’s law, though does not officially provide LD as a monetary remedy, permits the parties to pre-agree on a sum of damages in the contract?

Article 13 of the 2015 Civil Code states: “Individuals and legal entities whose civil rights are violated will be compensated for all loss and damage, unless otherwise agreed by the parties […].” The Code also stipulates in its Article 360 that “where there is any loss and damage resulting from a breach of an obligation, the obligor must compensate for the total loss and damage, unless otherwise agreed or provided by law.” The phrase “unless otherwise agreed” is a new point under the 2015 Civil Code. While its 2005 version only permits the parties to agree on the amount of damages in tort (Article 604), the 2015 Civil Code extends the permission for the parties’ agreement on damages in both tort and contractual relationship. Hence, the reading of Articles 13 and 360 of the 2015 Civil Code may reveal that the parties are allowed to pre-agree on a sum of damages in the contract rather than the actual damage. This seems to be inconsistent with the principle of actual and direct damage under Article 361 of the 2015 Civil Code and Article 302 of the 2005 Commercial Law as analyzed above.

In order to have an appropriate understanding of the relevant provisions of the 2015 Civil Code and the 2005 Commercial Law, let’s examine some trial practices showing the viewpoint of Vietnam’s courts on pre-estimation of damage compensation value,

In 1997, Ms. Hong (defendant) signed a contract to attend a refresher course in Japan with Suleco Company (claimant) under which Ms. Hong must pay Suleco Company a minimum compensation amount of JPY 2.5 million if she breaches the contract. The defendant later ran away and was asked for compensation by the claimant. The Court applied Article 310.2 of the 1995 Civil Code on actual damage compensation to invalidate the provision fixing a minimum amount of damages[5] and affirmed that the claimant was unable to provide any documents evidencing its actual losses. Accordingly, the Supreme Court did not accept the claimant’s request for damage compensation.

In 2016, Company T (claimant) and Company N (defendant) signed 11 rubber sale and purchase contracts. The defendant failed to timely deliver rubber to the claimant, forcing the claimant to purchase rubber from other sources with higher price as substitute. The claimant requested the defendant to compensate for the gap value between the market price of the non-delivered rubber and the contract price. The defendant did not accept the claimant’s request and only agreed to pay a compensation equaling 8 percent of the value of the non-delivered rubbers according to Clause VI of the contract which says that a party that unilaterally commits a contractual breach and causes damage to the other party will have to pay a compensation of 8 percent of the total contract value.

The Tay Ninh Court rejected the clause and affirmed that: “Clause VI of the contract is in non-compliance with the statutory regulations and unclear […] Under Article 302 of the 2005 Commercial Law, damage compensation must be based on actual, direct damage that the aggrieved party had to suffer and direct profits it should have earned. Damage compensation value can be determined only after a contractual breach has occurred, therefore it is unable to pre-estimate damage compensation value (if any) to provide in the contract, but only able to determine damage compensation value when there are an act of breach, the breaching party’s fault, and actual losses suffered by the aggrieved party.” The Tay Ninh Court therefore only accepted part of the claimant’s request, on the grounds that the claimant had actually purchased rubber in replacement for the non-delivered one with higher prices than prior estimation.

From the two above judgments, it can be clearly seen that Vietnamese courts have shown a consistent opinion on the determination of damage compensation value. Under Vietnam’s law, damage compensation must be based on actual and direct damage caused by the breaching party to the aggrieved party, and thus, the compensation value can be determined only after an occurrence of a breach gives rise to actual damage. Parties are not allowed to determine a fixed sum of damages in the contract in advance. This means LD Clause cannot be enforced in the form of a damage compensation clause, otherwise could be deemed contrary to Vietnam’s law principle of actual and direct damage.
Accordingly, the phrase “unless otherwise agreed” under Articles 13 and 360 of the 2015 Civil Code cannot be interpreted as a permission for the parties to determine damage compensation value in advance. Instead, it should be regarded as permission for the parties to agree on a waiver of a part of responsibility, that is, not until a breach occurs and actual damage is determined, would the parties be allowed to agree on a damage compensation value that can be lower than the total losses suffered by the aggrieved party.

Liquidated damages clause as a penalty

The 1995 Civil Code considers penalty a measure to ensure performance of civil obligations (Article 324). The 2005 Civil Code provides for penalty in the section “Performance of Civil Contracts” (Article 422) and allocates provisions on penalty in the sub-section “Performance of Contracts” (Article 418). Similarly, penalty is regarded as a remedy in case of non-performance of contract in both the 1997 Commercial Law 1997 (Article 222.2) and the 2005 Commercial Law (Article 292.2). Penalty is provided under the Civil Code and the Commercial Law with the aim of deterring a breach of contract. In other words, a penalty makes the parties aware that they must fully perform the contract so as not to be punished.[6] The purpose of penalty is in nature different from that of LD which is to compensate and mitigate losses.

However, penalty and LD have two other characteristics in common.

First, the application of both penalty and LD depends on the agreement between the parties. Under Article 300 of the 2005 Commercial Law, penalty is applied on the satisfaction of two conditions: (i) a breach occurs and (ii) the parties have reached an agreement on penalty in the contract.[7] Even in case a breach has occurred, if the parties have not yet agreed on penalty in advance, the aggrieved party may not exercise penalty towards the defaulting party.

Second, similar to LD Clause under which the parties pre-fix a sum of damages in the contract, the value of penalty is also pre-agreed by the parties in the contract. Nevertheless, while the pre-fixed value of damages under LD Clause is at the discretion of the parties and not restricted by law (though must still be reasonable and not disproportionate), the value of penalty under Vietnam’s law is restricted at a statutory cap, which is 8 percent of the value of the breached contractual obligation under the 2005 Commercial Law 2005 (Article 301) or 12 percent of the value of the breached contractual obligation for construction contracts for state-funded construction works, as prescribed in in the 2014 Construction Law (Article 146). The 2015 Civil Code (Article 418.2) allows the parties to agree on the penalty value without providing for any cap, but also regulates that “unless otherwise provided by the relevant law”. This means that penalty in a commercial contract and a construction contract must be subject to the cap of eight percent and twelve percent respectively under the specific laws.

Even though there still exists some differences between penalty and LD in terms of (i) function and (ii) cap of the penalty value, the most important common characteristic is that both penalty and LD are applied on the basis of agreement between the parties on a fixed value of penalty/damages. Despite the differences in function, if a breach of contract occurs, the aggrieved party is still entitled to a sum of money no matter the basis for this sum is LD Clause or a penalty clause. LD Clause cannot be identified with penalty, but the application of LD Clause in the form of penalty is feasible and not contrary to Vietnam’s law. The most substantial disadvantage is the penalty caps prescribed in the 2005 Commercial Law and 2014 Construction Law, making a penalty clause under Vietnam’ law unable to fully promote the nature of LD Clause.

Recommendation to apply liquidated damages clause in accordance with Vietnam’s law

Given the above analysis, Vietnam’s law neither officially adopts the validity of LD Clause nor allows the interpretation of LD Clause in the form of a damage compensation clause due to the contrast with the fundamental principle of making compensation based on actual and direct damage. In the context where Vietnam’s law only acknowledges two types of monetary remedies, which are damage compensation and penalty, the most appropriate way to apply LD in the contract is to interpret it as a penalty. This is a feasible and secure option which can help minimize the possibility that LD Clause can be invalidated by Vietnamese courts and arbitration tribunals. Nevertheless, the parties should be fully aware of the differences in nature between LD and penalty, especially the penalty cap of 8 percent and 12 percent under the 2005 Commercial Law and the 2014 Construction Law respectively. LD Clause can be applied and enforced in the form of a penalty clause, but certainly cannot promote its full nature in this way.

The difference in nature between LD and penalty also gives rise to different approaches to the principle of damage compensation under various jurisdictions. In common law jurisdictions, a monetary remedy clause is only enforceable when it functions as LD Clause and unenforceable if it is a penalty clause.[8] However in civil law jurisdictions, a penalty clause carries the characteristics of both LD and penalty.[9] Since Vietnam’s legal system is based on and influenced by the civil law system, in the context where LD Clause has not yet been adopted under Vietnam’s law, the interpretation of LD Clause in the form of a penalty clause should be recommended.-

[3] The principle of actual and direct damage is not only provided under the current regulations, but also consistently provided throughout the development of Vietnamese contractual regulations, including the 1989 Ordinance on Economic Contracts (Article 29.2), the 1995 Civil Code (Article 310.2), the 2005 Civil Code (Article 307), and the 1997 Commercial Law (Article 229).

[5] “Under Article 310.2 of the 1995 Civil Code, “the responsibility to compensate for physical damage is the responsibility to compensate for actual physical damage […]” The fact that the parties pre-agree on the minimum damages amount of JPY 2.5 million in the contract (which is not based on actual damage) does not comply with the above regulation, and thus is invalid.”

[7] Article 300 of the Commercial Law 2005: “Penalty for breach is a remedy whereby the aggrieved party requires the defaulting party to pay a penalty sum for breach of contract if so agreed in the contract, except in cases of immunity from liability stipulated in Article 294 of this Law.”

[8] If the liquidated damages are disproportional to the actual or anticipated damage, they can be declared a penalty, and thus unenforceable (See: Simas Vitkus, Penalty Clauses within different legal systems, Social Transformations in Contemporary Society, ISSN 2345-0126, 2013, p. 154; ReedSmith, Liquidated Damages and Penalty Clauses: A Civil Law versus Common Law Comparision, The Critical Path, 2008, p. 1).

[9]9 Two typical civil law nations are France and Germany. French law allows an identical understanding of LD Clause and penalty clause (i.e. Clause Pénale). Clause Pénale is provided with the aim of ensuring the contract performance and also compensating for the aggrieved party, therefore carries the characteristics of both penalty and LD (See: Articles from 1226 to 1233 of the French Civil Code). Similar is the approach under German law (See: Articles 340 and 341 of the German Civil Code).